Cost Of Capital

The cost of capital in operational terms refers to the discount rate that would
be used in determining the present value of the estimated future cash proceeds and
eventually deciding whether the project is worth undertaking or not. It is defined
as "the minimum rate of return" that a firm must earn on its investment for the
market value of the firm to remain unchanged.

In economic terms, there are two approaches to define cost of capital. According
to the first approach, it is the cost of acquiring the funds required to finance
the proposed project. That is the cost of capital is a borrowing rate of the
firm. Alternatively, cost of capital in terms of lending rates, may
refer to the opportunity cost of the funds to the firm i.e., what the firm could
have earned by investing the funds elsewhere. We use the term in the sense of borrowing
rate. This is mainly because firms which have to take capital budgeting decisions
would rarely, if ever invest funds outside. The approach is based on the borrowing
rate is therefore practical and more realistic.

According to the second approach, cost of capital is defined as the weighted
average of the cost of each type of capital. Each security capital
is given a weight according to either the book value or the market value, most practically
the market value, compared to the total security value of the firm. The term "security"
includes equity shares, preference shares, retained earnings, debentures and other
interest bearing securities. cost of capital is a borrowing rate of the firm.

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Basic Aspects of concept of Cost of capital

There are three basic aspects of concept of cost. They are:

It is not a cost as such.

It is the minimum rate of return.

It comprises the following 3 components:

Return at Zero risk level – This refers to the expected rate of
return when a project involves no risk whether business or financial.

Premium for business risk – The term business risk refers to the
variability in operating profit due to change in sales. The concept is higher the
risk, higher is the expected return.

Premium for financial risk – The term financial risk refers to
the risk on account of pattern of capital structure. In general, it can be said
that a firm having higher debt content in its capital structure is more risky as
compared to a firm which has comparatively low debt content.

The above three components of the cost of capital may be put in the form of following
equation:

It is relevant in the field of managerial decision
as this dynamic concept is affected by a company’s capital structure, its’ financing
plans for the future and any changes in the rate of earnings.

When taking decisions based on Net Present Value method,
the cost of capital is usually the discount rate that discounts the cash inflows.

It is important in designing the capital structure
of a firm.

It is helpful in evaluation of expansion projects,
evaluation of the financial performance of the top management through the comparison
of the projected overall cost of capital and the actual cost incurred in raising
the required funds.

It is a vital factor in management decision about the
method of financing at a given time. Costs of various sources of capital at a given
time influence the management’s decision in favor of a certain capital.

Importance of Cost of capital:

Cost of capital can be classified as follows:

Explicit cost of capital – It may
be defined as the discount rate that equates the present value of funds received
by the firm net of underwriting costs, with the present value of expected cash outflows.
It is the rate of return of the cash flows of financing opportunity. It is, in other
words, the internal rate of return the firm pays for financing.

Implicit cost of capital - The implicit
cost may be defined as the rate of return associated with the best investment opportunity
for the firm and its shareholders that will be foregone if the project presently
under consideration by the firm were accepted.

Future cost of capital – It is the
projected cost of capital used in designing the capital structure to minimize the
future cost of capital and to control it.

Historical cost of capital – It is
the cost which has already been incurred for financing a particular project. These
costs are useful in projecting future costs.

Specific cost of capital – It is the
cost associated with particular component of capital structure.

Average cost of capital – It is the
average of various cost of the weighted average of the costs of each component of
funds employed by the concern, the weights being the proportion of each component
in the capital structure.

Combined cost of capital – It includes
the cost of capital from all sources namely, debt, equity, preference capital and
retained earnings. It is also called as the weighted cost of capital.

Marginal cost of capital – Marginal
cost of capital is the weighted average cost of new funds raised by the firm. For
capital budgeting and financing decisions, the marginal cost of capital is the most
important factor to be considered.

Cost of capital comprises of cost of each specific source of finance. They are: